Financial sector investment bankers must step in between auditors and politicians at odds over how banks account for allowances for loan losses.

Certain banking regulators and politicians have pressured banks to predict future losses based on economic forecasts and set aside adequate reserves. But that can only be done at the risk of violating existing accounting standards and rules of the U.S. Securities and Exchange Commission. In the U.S. the Financial Accounting Standards Board guidance on accounting for contingencies, FASB 5, require banks to record losses as they are incurred, not based on predictions of future events. Similar guidelines are in place in the U.K., as well as in continental Europe and Asia.

Indeed, in the U.S. some big banks have been adding to their credit reserves. Wells Fargo & Co. (WFC) added $1.3 billion in the first quarter, Bank of America Corp. (BAC) raised its own to $4.6 billion. But that was merely reflecting losses that had already occurred, not establishing a cushion for future adverse developments.

This divide in thinking between populist sentiment and auditors was particularly controversial for both Fannie Mae (FNM) and Freddie Mac (FRE). Freddie Mac's management attempted to explain the issue, but the U.S. Congress wasn't listening because these weren't the answers they wanted.

The loss provisioning for banks is similar to the insurance sector in this regard. When a hurricane strikes a locale, the insurance company books an estimate of losses even before they are reported by policyholders.

This estimate is recorded immediately, although some time will pass between the day when the hurricane damages the insured properties and when the evacuees return to their homes to assess the damage and report the claims. However, the insurance company doesn't attempt to project future losses for storms that have not yet occurred because they cannot do so.

 
Banks Vs. Politicians

Unfortunately, banks are under pressure from politicians, who embrace the populist sentiment that bank executives must be doing something wrong if they have to keep boosting their loss reserves.

Dorsey Baskin, regional partner in charge of professional standards at accounting firm Grant Thornton LLP, said that the confusion is the result of an expectation that the allowance for loan losses for banks represents an estimate of all future losses, so the balance sheet has been netted down, which is not the case.

One obvious solution is to change the accounting rules. But that's not easy. Complexities will arise on how to correctly estimate losses triggered by events that have not yet taken place. Controversy will arise from the possibility that bank executives can smooth earnings. Tax authorities will object that reserving for future unknown losses reduces taxable corporate income.

The Bank of Spain addressed some, but not all, of these issues when it introduced a "statistical provisioning" system. The Spanish central bank was concerned that as bank loan portfolios increased during the economic boom, loan loss provisions were not keeping pace with potential credit losses on the new loans.

The Spanish system allows provisioning for fixed losses that have been incurred and variable losses that are estimated. This is set against a portion of the interest income expensed over the life of the loan. This is not a perfect solution, but it does have some advantages. It mitigates income smoothing.

A number of accounting firms and regulators have proposed "dynamic regulatory capital provisioning," which would increase loan loss allowances in strong economies and decrease them in weak ones.

But this also distorts financial reporting, particularly comparisons across periods of time. This may also reduce taxable corporate income. So it could run into problems with politicians at a time when the U.S. is dealing with its deficit.

But banks can work in tandem with investment bankers to come up with some solutions. One solution could be structuring securities convertible to common equity when a trigger is reached or an index-based security to track loan losses.

This could help the banks to underwrite more loans as well as assure regulators on potential losses. Either way bankers should now step in and work with the regulators and auditors and suggest solutions that satisfy all.

(Donna Childs is a senior columnist for Dow Jones Newswires on the financial services sector. She has 20 years of financial industry experience, working in investment banking and reinsurance. She can be reached at 201-938-5456 or by email at donna.childs@dowjones.com. Dow Jones Newswires is enhancing its news, commentary and analysis for the investment banking community, and is providing it on this service temporarily. To ensure continued access to the best of Dow Jones news and opinion on companies, sectors and deals for bankers and research analysts, please contact investmentbanker@dowjones.com.)

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